Stocks’ short-term signals are bullish but Peter Lynch’s long-term investing advice still applies

Lynch popularized the idea to invest in what you know — meaning to own shares of the companies that you are familiar with. He wrote three bestselling books on his ideas, including actually going in person to observe what people were buying first-hand. 

Lynch was famous for visiting the companies that he wanted to buy stock in. For example, before buying shares in an automobile stock, Lynch would go to the dealer showroom, converse with the salespeople, and check out the inventory. 

His advice, while sounding simplistic, is actually brilliant. After all, most people spend more time and effort researching buying a new refrigerator than a stock. I made that mistake when I first starting investing, sinking $50,000 into shares of a Texas cell phone company that I had never even heard about. Why? Because an acquaintance who knew more than I did about the stock market said I should. “You can double your money,” he promised. Famous last words.  

Instead of doubling my money, I lost half of it within months when the company nearly went bankrupt after some questionable accounting maneuvers. It was also the first and last time I ever bought stocks on margin. 

Using margin, the broker allowed me to use my original $25,000 to buy another $25,000 worth of stock (2-1 margin). When the stock plunged, I not only lost money on my original investment, I also owed the brokerage for the money I borrowed. Mismanaging margin is one of the ways that many investors get into trouble when their stocks go against them. 

Study balance sheets and stock charts 

Had I followed Lynch’s advice and done some basic research, I would have discovered that the so-called cell phone company was a scam. It was being promoted by fake press releases and inflated posts on social media. 

In hindsight, I could have flown to Texas and visited the company. I would have discovered that it had only two employees. It would have been a lot cheaper to fly there than lose $25,000. I also could have studied the company’s balance sheet, looked at a stock chart, and studied its earnings reports. It sounds like common sense, but think of how many people buy stocks every day without doing the most basic research, what is referred to as exercising “due diligence.” Others call it “doing your homework.” 

How Lynch handled bear markets

From my interview with Lynch, I learned that he doesn’t make predictions. “I have no idea what the market will do over the next one or two years,” he told me. “What I do know is that if interest rates go up, inflation will go up and in the near term the stock market will go down. I also know that once every 18 months the market has a decline of 10%. These are called corrections. We could easily have a 10% correction. Perhaps one out of three of these corrections turns into a 20% to 25 % correction. These are called bear markets.”

Lynch took market corrections in stride, including bear markets. Although he disliked bear markets since he was a long-only manager and hated losing money when one occurred, he didn’t panic. “If you understand what companies you own and who their competitors are,” Lynch said, “you’re in good shape. You don’t panic if the market goes down and the stock goes down. If you don’t understand what you own and don’t understand what a company does and it falls by half, what should you do? If you haven’t done your research, you might as well call a psychic hotline for investment advice.”

I learned from Lynch that although bear markets are inevitable, they cannot be predicted. That is why before one occurs, you must evaluate what stocks or funds you own. If you are confident about your investments, you won’t get shaken out.

For me, it means reducing some of my positions, especially given the U.S. market’s current technical indicators. Although the market has been on a 12-year bull run, it is still vulnerable to a steep correction, or worse, a bear market. That is why it’s more important than ever to do the basic research (i.e. study balance sheets and stock charts). 

For short-term traders, here are what some solid technical indicators are saying now about the U.S. market as of the April 8 close.

Moving averages: Bullish. The S&P 500 SPX, +0.42% is on a tear — well-above its 50-, 100- and 200-day moving averages. According to moving averages, all systems are “go.” 

RSI (relative strength indicator): Overbought. RSI, which measures overbought/oversold conditions, is telling us the market is getting close to the danger zone. When RSI hits 70 or higher, it is a danger sign. By the way, the S&P 500’s weekly RSI is currently at 69.14. Consider this: In less than three weeks (since March 25), the S&P 500 has moved higher by about 250 points. The Dow Jones Industrial Average DJIA, +0.17% RSI is 70.86, while the Nasdaq COMP, +1.03% is at 63.73.

If the market keeps rising, short-term risks rise. Remember that markets or stocks can remain overbought or oversold for long time periods. For example, right now some individual stocks have RSI levels of 90 or higher, and yet, they are not falling. RSI is best used as a clue, but not to time the market. 

MACD (Moving average convergence divergence): Neutral. Many short-term traders rely on the MACD to give reliable trading signals. At the moment, while MACD for the S&P 500 is above its zero line (positive), it is also even with its nine-day Signal Line (neutral). At the moment, MACD is not giving a clear signal for the S&P 500. Meanwhile, MACD for the Dow is bullish (MACD above zero line and nine-day signal line) and is neutral for the Nasdaq.

VIX (CBOE Volatility Index): Showing no fear. The VIX, VIX, -1.22% which measures the implied volatility of the S&P 500, has been falling for months, and is in the basement (it’s currently just under 17.0). This tells us there is low volatility and little fear. Few expect anything bad to happen to the stock market, and if stocks slide, many believe the market “will come back.” Only Mr. Market knows if this is true. 

Bottom line: If you are a long-term investor, Lynch’s methods and ideas are excellent. If there is a bear-market hiccup, use the opportunity to buy shares of stock or indexes that you have researched. 

If you are a short-term trader, there are clear warning signs that the U.S. market is too good to be true. Most importantly, don’t own anything you don’t understand, or that you got from a tip from a neighbor or a tout on TV. And be wary about buying on margin. 

Michael Sincere (michaelsincere.com) is the author of “Understanding Options,” “Understanding Stocks,” and his latest, “Make Money Trading Options,” which introduces simple option strategies to beginners. 

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